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Class 25 - Breakeven Analysis

This document provides an overview of breakeven analysis, which examines the relationship between changes in volume, total sales revenue, expenses, and net profit. It defines key terms like breakeven point and margin of safety. The document presents the breakeven formula and shows how to calculate breakeven using an algebraic or graphical method. It discusses how breakeven analysis can be used for decision making in areas like marketing, operations, and facility location. The document also introduces payback period analysis and how to calculate and compare payback periods for different alternatives.

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Pruthvi Prakasha
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101 views22 pages

Class 25 - Breakeven Analysis

This document provides an overview of breakeven analysis, which examines the relationship between changes in volume, total sales revenue, expenses, and net profit. It defines key terms like breakeven point and margin of safety. The document presents the breakeven formula and shows how to calculate breakeven using an algebraic or graphical method. It discusses how breakeven analysis can be used for decision making in areas like marketing, operations, and facility location. The document also introduces payback period analysis and how to calculate and compare payback periods for different alternatives.

Uploaded by

Pruthvi Prakasha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Breakeven Analysis

Introduction
Breakeven analysis examines the short run
relationship between changes in volume and
changes in total sales revenue, expenses and
net profit
Also known as C-V-P analysis (Cost Volume
Profit Analysis)
C-V-P analysis is an important tool in terms of
short-term planning and decision making

Key Terminologies
Break even point-the point at which a
company makes neither a profit or a loss.
Contribution per unit-the sales price minus
the variable cost per unit. It measures the
contribution made by each item of output to
the fixed costs and profit of the organisation.
Margin of safety-a measure in which the
budgeted volume of sales is compared with
the volume of sales required to break even

Break Even Formula


Contribution per unit
Is the selling price of a product less variable costs
per unit.
Fixed Cost

Break-even level of output=

Contribution per unit

Algebraic Solution
Equate total revenue and total cost functions and solve for
Q
TR = P x Q
TC = FC + (VC x Q)
TR = TC
P x QB = FC + VC x QB
(P x QB) (VC x QB) = FC
QB (P VC) = FC
QB = FC/(P VC)

Break-even Formula Example


Fixed costs = $200,000
Contribution per unit = $50
What is the Break-even level of output?
Break-even level of output=

Fixed Cost
Contribution per unit

200,000 / 50 = 4000 units

Graphical Method
The break-even graph shows 3 pieces of
information:
Fixed costs
Total costs (fixed costs + variable costs)
Sales revenue (selling price * units sold)

Graphical Method Example


Sales Revenue

Profit at full capacity

Costs and revenue

Total Costs

BE

Variable Costs

Fixed Costs

Break-even point

Output
Full
Capacity

The maximum profit is made when the maximum output is produced.

Profit vs Loss
Sales Revenue

Profit at full capacity

BE

Loss

Profit

Costs and revenue

Total Costs

Variable Costs

Fixed Costs

Break-even point

Output
Full
Capacity

Profits are to the right of the break-even point.


Losses are to the left of the break-even point.

Margin of Safety
The difference between budgeted or actual
sales and the breakeven point
The margin of safety may be expressed in
units or revenue terms
Shows the amount by which sales can drop
before a loss will be incurred

Margin of Safety
Sales Revenue

Profit at full capacity

Costs and revenue

Total Costs

BE

Safety margin

Variable Costs

Break-even
point

Fixed Costs

Current
Output

Full
Capacity

If margin of safety is
positive, production
is above break even.
If margin of safety is
negative, production
is below break even.

Output

Margin of safety is the amount by which the sales level exceeds


the break-even level. If sales drop below this level, a loss will occur.

Additional Uses of Break-even Analysis


Marketing decision: The impact of price increases
This raises sales revenue line at all quantities assuming
that sales do not decline which may be unlikely.

Operations Management decision: Purchase of new


equipment with lower variable costs
This lowers the variable cost line at each quantity level.

Choosing between two locations for a new factory


with different fixed and variable costs.

Target Revenues & Profits


A modified break-even formula can be used to
determine a target profit level.
Target profit level of output=

Fixed Costs + Target Profit

Contribution per Unit


Target profit is $25,000
Fixed Costs are $200,000
Contribution per unit $50

4500 =
Units

200,000 + 25,000

50

Break-even Revenue
Break-even Revenue is the amount of revenue
needed to cover both fixed and variable costs so that
the business breaks even.
Break-even Revenue =

Fixed Costs

1 (Variable cost / Price)

This is helpful in a service business.


Story: If the monthly fixed costs of a law practice are $60,000, lawyers are paid
$15 per hour, and clients are charged a price of $30 per hours, what is the
break-even revenue?
How many hours must they bill?
60,000
= $120,000
1 (15 / 30)

Breakeven Between Two Alternatives


To determine value of common variable between 2 alternatives, do the
following:
1. Define the common variable
2. Develop equivalence PW, AW or FW relations as function of common
variable for each alternative
3. Equate the relations; solve for variable. This is breakeven value

Selection of alternative is based on


anticipated value of common variable:
Value BELOW breakeven;
select higher variable cost
Value ABOVE breakeven;
select lower variable cost

Example
Alternative A (Make): First cost= 18000,
Salvage Value= 2000 and Per Unit cost of 0.4
Alternative B (Buy): 1.5 per unit.
MARR= 15% and Life= 6 Years

Example: Two Alternative Breakeven Analysis


Perform a make/buy analysis where the
common variable is X, the number of units
produced each year. AW relations are:
AWmake = -18,000(A/P,15%,6)
+2,000(A/F,15%,6) 0.4X

AW, 1000
$/year

AWbuy

8
7

AWbuy = -1.5X

Solution: Equate AW relations, solve for X

-1.5X = -4528 - 0.4X


X = 4116 per year

Breakeven
value of X

AWmake

4
3
2
1

If anticipated production > 4116,


select make alternative (lower variable cost)

X, 1000 units per year

Payback Period Analysis


Payback period: Estimated amount of time (np) for cash inflows to recover an
initial investment (P) plus a stated return of return (i%)

Types of payback analysis: No-return and discounted payback


1. No-return payback means rate of return is ZERO (i = 0%)
2. Discounted payback considers time value of money (i > 0%)

Caution: Payback period analysis is a good initial screening


tool, rather than the primary method to justify a project or
select an alternative (Discussed later)

Payback Period Computation


Formula to determine payback period (np)
varies with type of analysis.

NCF = Net Cash Flow per period t

Eqn. 1
Eqn. 2
Eqn. 3
Eqn. 4

Points to Remember About Payback Analysis


No-return payback neglects time value of money, so no
return is expected for the investment made
No cash flows after the payback period are considered in the
analysis. Return may be higher if these cash flows are
expected to be positive.
Approach of payback analysis is different from PW, AW, ROR
and B/C analysis. A different alternative may be selected using
payback.
Rely on payback as a supplemental tool; use PW or AW at the
MARR for a reliable decision
Discounted payback (i > 0%) gives a good sense of the risk
involved

Example: Payback Analysis


First cost, $
NCF, $ per year
Maximum life, years

System 1
12,000
3,000
7

System 2
8,000
1,000 (year 1-5)
3,000 (year 6-14)
14

Problem: Use (a) no-return payback, (b) discounted payback at


15%, and (c) PW analysis at 15% to select a system. Comment
on the results.

Solution: (a) Use Eqns. 1 and 2


np1 = 12,000 / 3,000 = 4 years
np2 = -8,000 + 5(1,000) + 1(3,000) = 6 years
Select system 1

Example: Payback Analysis (continued)


System 1
First cost, $
NCF, $ per year

12,000
3,000

Maximum life, years

System 2
8,000
1,000 (year 1-5)
3,000 (year 6-14)
14

Solution: (b) Use Eqns. 3 and 4


System 1: 0 = -12,000 + 3,000(P/A,15%,np1)
np1 = 6.6 years
System 2:

0 = -8,000 + 1,000(P/A,15%,5)
+ 3,000(P/A,15%,np2 - 5)(P/F,15%,5)
np1 = 9.5 years

Select system 1
(c) Find PW over LCM of 14 years
PW1 = $663
PW2 = $2470

Select system 2
Comment: PW method considers cash flows after payback period.
Selection changes from system 1 to 2

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